The pandemic has shifted certain aspects of our society.
I believe that many of these shifts will revert back to the mean, but other changes will likely endure.
This will create business winners at the expense of other businesses.
Naturally, the investors who pick the right businesses will also “win”.
As a long-term investor, I see this as an exciting opportunity to jump on to something that could benefit from a tailwind that lasts a generation.
I’d make an argument that picking the right businesses is easier when using the right strategy.
The strategy I’ve chosen is dividend growth investing.
This strategy advocates buying and holding shares in world-class enterprises that pay growing dividends.
Growing profits fund those growing dividends.
And the growing profits are produced by selling the world the products and/or services it demands.
This strategy is so powerful because it basically “funnels” you right into some of the world’s best businesses.
The Dividend Champions, Contenders, and Challengers list says it all.
Following the dividend growth investing strategy helped me to retire in my early 30s, as I share in my Early Retirement Blueprint.
Indeed, my real-money dividend growth stock portfolio, which I call the FIRE Fund, produces enough five-figure passive dividend income for me to live off of.
As great as this strategy is, valuation at the time of investment is always critical.
Price determines what you pay. But value determines what you get for your money.
An undervalued dividend growth stock should provide a higher yield, greater long-term total return potential, and reduced risk.
Price and yield are inversely correlated. All else equal, a lower price will result in a higher yield.
That higher yield correlates to greater long-term total return potential.
This is because total return is simply the total income earned from an investment – capital gain plus investment income – over a period of time.
Prospective investment income is boosted by the higher yield.
But capital gain is also given a possible boost via the “upside” between a lower price paid and higher estimated intrinsic value.
And that’s on top of whatever capital gain would ordinarily come about as a quality company naturally becomes worth more over time.
These dynamics should reduce risk.
Undervaluation introduces a margin of safety.
This is a “buffer” that protects the investor against unforeseen issues that could detrimentally lessen a company’s fair value.
It’s protection against the possible downside.
Picking the right businesses within the right strategy at the right valuations almost guarantees you exceptional investment results over the long run.
Fortunately, the process of valuation isn’t as complex as it might appear to be.
Fellow contributor Dave Van Knapp’s Lesson 11: Valuation has greatly simplified the process.
Part of a larger and more comprehensive series of “lessons” on dividend growth investing, it provides a valuation guide that can be applied toward almost any dividend growth stock.
With all of this in mind, let’s take a look at a high-quality dividend growth stock that appears to be undervalued right now…
Lowe’s Companies Inc. (LOW) is a large home improvement retailer based in the United States.
Founded in 1921, Lowe’s is now a $134 billion (by market cap) retailing behemoth that employs 280,000 people.
They operate nearly 2,000 stores in the US and Canada.
The typical store averages around 110,000 square feet in size and offers 35,000 different products. In addition, they offer hundreds of thousands of products via their special order system and e-commerce channel.
There’s a huge trend that’s been playing out in the United States for at least the last year.
It’s one where people are starting to move away from cramped urban housing in favor of more spacious suburban homes. This has seemingly been induced by a variety of factors, including (but not limited to) the pandemic.
While this trend has a lot of knock-on effects, one of the most obvious beneficiaries of such a trend is a home improvement retailer.
That’s simply because large homes require significantly more upkeep than a small apartment, not to mention the fact that it introduces the pride of ownership and desire for customized upgrades.
As the second-largest home improvement retailer in the world, Lowe’s is reaping rewards.
That should translate to more profits and bigger dividends for shareholders.
Dividend Growth, Growth Rate, Payout Ratio and Yield
Already, Lowe’s has increased its dividend for 59 consecutive years.
That’s one of the lengthiest dividend growth track records in existence, making them a Dividend Aristocrat more than twice over.
Their 10-year dividend growth rate is an impressive 18.9%.
And while you might think there’d be a dramatic slowdown at nearly 60 years into dividend raises, you’d be wrong.
Their most recent dividend increase, announced in May, came in at an astounding 33.3%.
With a low payout ratio of 34.8%, there’s a lot of room for more double-digit dividend increases.
Plus, the stock yields a market-beating 1.7%, which is right in line with the stock’s five-year average yield.
Revenue and Earnings Growth
Fantastic dividend metrics.
As fantastic as they are, though, they’re looking backward.
Investors risk today’s capital for tomorrow’s rewards.
It’s future dividend raises and returns we care most about.
As such, I’ll now build out a forward-looking growth trajectory, which will later help us to estimate the stock’s intrinsic value.
I’ll first show you what the company has done over the last decade in terms of top-line and bottom-line growth.
Then I’ll compare that to a near-term professional prognostication for profit growth.
Blending the proven past with a future forecast in this way should give us a good idea as to where the business is going from here.
Lowe’s grew its revenue from $50.208 billion in FY 2011 to $89.597 billion in FY 2020.
That’s a compound annual growth rate of 6.65%.
I see that as a very strong top-line growth rate for such a large sales base.
Meanwhile, earnings per share increased from $1.43 to $7.75 over this period, which is a CAGR of 20.66%.
We can now see where that huge dividend growth came from; it came from huge EPS growth.
A rather substantial buyback program drove much of this excess bottom-line growth. They’ve reduced the outstanding share count by 41% over the last decade.
Moving forward, CFRA is forecasting that Lowe’s will compound its EPS at an annual rate of 5% over the next three years.
I’m not real sure why CFRA has such a low figure here. It doesn’t really square with the historical growth rate, the current sales environment, or any of the glowing praise CFRA heaps upon the business.
To wit, CFRA says this: “LOW is still in the middle innings of a transformation with improved sales execution, inventory controls, better supply chain, and revamped stores.”
They also say this: “LOW is executing better, in our view, especially on customer service and store management.”
So if they’re executing better, I’m not sure why there would be an expectation for such a meaningful slowdown in growth. If we look at Lowe’s five-year EPS CAGR from FY 2011 to FY 2015, before the urban flight occurred, it was over 17%.
On the other hand, the last 12-18 months has been rather exceptional for the business, and there’s been a bit of a pull-forward effect on sales.
I think Lowe’s should do at least as well as it historically has. But there’s a good chance the business does even better moving forward.
And that would easily set them up for double-digit dividend growth for the foreseeable future, especially after factoring in the low payout ratio.
Moving over to the balance sheet, they have a rock-solid financial position.
The long-term debt/equity ratio, at 14.38, looks very high. But that’s because of low common equity, not an unsustainable amount of long-term debt. Their long-term debt load of ~$20 billion is actually quite low for a $135 billion company.
Meantime, the interest coverage ratio of slightly under 10 shows that the business has no issues with servicing its debt.
Profitability is robust, with some improvement of late.
Over the last five years, the firm has averaged annual net margin of 5.07% and annual return on equity of 119.41%.
Net margin has been nicely marching upward over the last few years.
This is a high-quality business across the board.
And with large economies of scale, pricing power, brand recognition, product specialization, and an expert workforce that guides consumer purchases, there are durable competitive advantages in place.
Of course, there are risks to consider.
Litigation, regulation, and competition are omnipresent risks in every industry.
Retailing is extremely competitive, limiting margins.
Any major changes in the way consumers spend money can affect the business. One near-term concern is the possible pent-up demand for services, which could result in consumer spending flowing away from home projects.
The company’s stores are only in North America, which means no international growth potential at this time.
A red-hot US real estate market could correct at any time, which would likely negatively impact the demand for general spending on homes.
I view these risks as very manageable, particularly if the investment is made at an attractive valuation.
After correcting off of its 52-week high of $215.22, I see the stock as attractively valued here…
Stock Price Valuation
The P/E ratio is sitting at 20.7.
That’s well off of its own five-year average P/E ratio of 24.8.
Admittedly, as I noted earlier, a pull-forward effect could be in play. But there’s still a sizable gap present.
That gap is also present in the cash flow multiple.
The current P/CF ratio of 12.7 is quite a bit lower than its five-year average of 14.5.
So the stock looks cheap when looking at basic valuation metrics. But how cheap might it be? What would a rational estimate of intrinsic value look like?
I valued shares using a two-stage dividend discount model analysis.
I factored in a 10% discount rate, a 10-year dividend growth rate of 12% and a long-term dividend growth rate of 8%.
I’m assuming the continuation of low-double-digit dividend growth for the next decade, as the business’s strong underlying EPS growth and low payout ratio can support this for years to come.
While this might look high, it’s almost 1/3 that of what the most recent dividend increase was.
In addition, it’s not a permanent expectation.
I believe the dividend growth rate will settle into a high-single-digit range, as that would be in line with what I’d customarily expect from a world-class retailer like this.
The DDM analysis gives me a fair value of $242.30.
The reason I use a dividend discount model analysis is because a business is ultimately equal to the sum of all the future cash flow it can provide.
The DDM analysis is a tailored version of the discounted cash flow model analysis, as it simply substitutes dividends and dividend growth for cash flow and growth.
It then discounts those future dividends back to the present day, to account for the time value of money since a dollar tomorrow is not worth the same amount as a dollar today.
I find it to be a fairly accurate way to value dividend growth stocks.
I don’t see my valuation as all that aggressive, yet the stock looks notably undervalued.
But we’ll now compare that valuation with where two professional stock analysis firms have come out at.
This adds balance, depth, and perspective to our conclusion.
Morningstar, a leading and well-respected stock analysis firm, rates stocks on a 5-star system.
1 star would mean a stock is substantially overvalued; 5 stars would mean a stock is substantially undervalued. 3 stars would indicate roughly fair value.
Morningstar rates LOW as a 2-star stock, with a fair value estimate of $165.00.
CFRA is another professional analysis firm, and I like to compare my valuation opinion to theirs to see if I’m out of line.
They similarly rate stocks on a 1-5 star scale, with 1 star meaning a stock is a strong sell and 5 stars meaning a stock is a strong buy. 3 stars is a hold.
CFRA rates LOW as a 4-star “BUY”, with a 12-month target price of $220.00.
I think Morningstar is being way too conservative here. Averaging the three numbers out gives us a final valuation of $209.10, which would indicate the stock is possibly 10% undervalued.
Bottom line: Lowe’s Companies Inc. (LOW) is a world-class home improvement retailer that is benefiting from a huge trend that is playing out across the United States. With 59 consecutive years of dividend increases, double-digit dividend growth, a market-beating yield, a very low payout ratio, and the potential that shares are 10% undervalued, this Dividend Aristocrat deserves to be on every dividend growth investor’s shopping list.
P.S. If you’d like access to my entire six-figure dividend growth stock portfolio, as well as stock trades I make with my own money, I’ve made all of that available exclusively through Patreon.
Note from DTA: How safe is LOW’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 93. Dividend Safety Scores range from 0 to 100. A score of 50 is average, 75 or higher is excellent, and 25 or lower is weak. With this in mind, LOW’s dividend appears Very Safe with a very unlikely risk of being cut. Learn more about Dividend Safety Scores here.
This article first appeared on Dividends & Income
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